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What are Spreads in Trading?
Last Update: 2024-11-16
As a participant in the FOREX market, you will need to learn many terms. A term you will encounter most often is the spread, which is broadly defined as the difference between your FOREX broker's sell rate and buy rate when exchanging or trading currencies. Understanding what this term means, and, more importantly, how to apply it, will set you up to read quotes more clearly and to make trading decisions faster.
We have written this short article to explain more about spreads so you can navigate the FOREX trading market better.
What are Spreads?
FOREX trading is all about exchanging one currency for another. To create a universal language in which everyone understands the value of a currency in relation to another, currency A is quoted in terms of its price in currency B. This is known as the exchange rate. The spread is the difference between the exchange rate that a broker sells a currency and at which the broker buys that currency.
Let us explain further and show you spreads in action. When you invest in a currency at the prevailing exchange rate, otherwise known as the spot rate, and later sell it for a profit, the difference between what you bought it for and what you sold it for is your gain (or loss) on the spread.
How Currencies are Quoted
When it comes time to trade FOREX and work through a broker, currencies are always quoted in pairs, for example, the Australian dollar versus the euro (AUD/EUR). The first currency is called the base currency, and the second currency is called the quote currency. Spreads vary according to market demand, economic conditions and other factors, like the time of day (opening hours vs. peak trading) or even the time of year (close to holidays).
When FOREX brokers offer their currency trading and exchange services, they must use a term that is an extension of the spread, known as the bid-ask spread. Let us now introduce you to the bid-ask spread to show the FOREX world in action. The bid price is how much your broker is willing to pay for a currency when acting as a buyer, while the ask price is the rate the broker will pay for that same currency when acting as a seller.
If you have ever traveled to another country and needed to use a bureau de change, you will understand that it is providing you with much the same service in an airport as FOREX brokers provide to retail traders in the real world. For example, let us say you are an Australian tourist visiting Europe. When you land at the airport in Europe, the bureau de change presents you with the cost of purchasing euros as follows:
EUR 1 = AUD 1.48 / AUD 1.55
The difference between the two AUD values is the spread. The higher price (AUD 1.55) is how much you will pay to buy one euro. In our example, you purchase the amount of euros you need for your trip and leave the airport. Perhaps at the end of your trip you return to the same bureau de change and find the rates unchanged. You have some euros left over and need to sell them back to the bureau de change. This time, the lower price (AUD 1.48) is the rate at which you must sell your remaining euros to get back some Australian dollars. You will note that the bureau de change makes a profit from these transactions through the difference in the bid-ask spread. This is because it is a market maker and generating profit is completely normal. We will explain more in the next section.
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How Market Makers Determine the Spread
If we take our example and apply it to the overall FOREX market, the same principles apply. The FOREX market is a virtual world where intermediaries known as market makers coordinate transactions (just like the bureau de change). They are often highly-trained specialists, individuals or small agencies, based in cities all over the world.
Remember, it is the big players, like large financial institutions, that drive the most FOREX volumes, not retail traders, who are but a small part of the ecosystem. Market makers are skilled and experienced at ensuring an orderly flow of buy and sell orders for the currencies in which they work. They have many clients around the globe and they are skilled at brokering massive transactions.
There is implied risk in this process as prices can change quickly, so market makers must insert a premium that involves elements of their own profit plus a premium for risk. In coordination, market makers across the ecosystem help determine the spread equilibrium of global currencies. For you as a retail trader, it helps to understand that your broker procures its FOREX from a market in which prices are influenced by market makers, and this is how you are presented with the spreads you see on your FOREX quote.
The Bottom Line
When you come to understand spreads, you can improve your trading success because you will learn how to apply them quickly and correctly to trades you are considering. It also helps to know what influences spread so you can visualize your place and your broker’s place in the FOREX ecosystem.
